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Measuring Market Strength: Technical Primer - 17431 views
BALTIMORE (Stockpickr) -- There's an old saying on Wall Street that "it's a market of stocks, not a stock market." In large part, that's true -- single stocks often trade in directions that are divergent from the broad market; identifying them is the domain of the successful trader.
But even with that in mind, it's a huge mistake to underplay the importance of the stock market as a whole.
That's because, clever sayings aside, the vast majority of stock movements are highly correlated with one another, and with the collective market itself. That's become more evident than ever in the last few decades, as index funds became the most popular investment choice for Americans' retirement portfolios. With exposure to a diversified basket of stocks that's designed to track "the market," these funds are directly impacted by losses in the indexers they track.
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On a practical level, it makes a lot of sense that most stocks trade in tandem. It has more to do with the flow of funds into and out of the market than with the specifics of any particular stock -- as investors tried to liquidate stock positions and free up cash in the recession of 2008, for instance, they were selling the good alongside the bad in order to stay solvent. In the process, even fundamentally sound stocks got pushed significantly lower as the broad market crashed.
But investors don't need to be beholden to the market. By measuring market strength, you can target asset classes that look to be the strongest performers when times are tough, and you can spot early signs of broad market reversals when times are good. Today, we'll explore some popular measures of market strength.
Relative or Absolute Market Strength
Market strength is a broad term that can mean a lot of things, depending on how we define it. Market strength can be a measure of a market's power to perform either on a relative basis (vs. other markets) or on an absolute basis (vs. its own historical levels of momentum and investor participation).
First, we'll take a look at the
relative strength of a market. Relative strength is a technical analysis metric that's not relegated to intermarket analysis (that is to say, it can be used for individual stocks just as effectively), but it's arguably at its most powerful when used to help select the strongest asset class.
Essentially, relative strength is just the ratio of one asset to another over a period of time. By taking the daily close of the S&P 500 divided by the daily spot price of gold, for example, you'll get the relative strength of the S&P (or more broadly, of stocks) vs. gold. Because relative strength is a ratio of two disparate items, it's not the value of an asset's relative strength but rather its change over time that bears monitoring.
By looking at relative strength of various asset classes over the long-term, technical traders can determine when it makes sense to rotate a portfolio from a relatively weaker asset to relatively stronger assets. Of course, it's crucial to monitor the assets themselves at the same time -- using relative strength alone, it's possible to invest in the "least worst" of two declining assets.
The abundance of new, commodity, currency, and foreign equity exchange traded funds has made this method of trend trading especially popular in recent years.
Using Absolute Strength to Spot Market Reversals
The other way to look at market strength is to compare a stock's current metrics against historical ones. By doing this, traders can get a sense of where in its investment cycle a market may be -- and also discern how much strength a trend has and when a reversal may be likely to occur.
It's the latter half of absolute strength measures that makes them particularly actionable.
In this context, measuring market strength is called market breadth. It focuses on how individual issues in the market are contributing to its overall performance. The reasoning is simple: If an index such as the S&P 500 is increasing but those increases are coming from few stocks, the setup suggests that the uptrend is losing strength and is more likely to reverse.
As you might expect, many indicators exist to help identify market breadth -- far too many to detail for the purposes of this primer. That said, it does make sense to take a look at the most popular: the Advance/Decline Line, or A/D Line.
The A/D line is essentially a running tally of the market's advancing stocks minus the market's declining stocks. As with relative strength, it's not the value of the A/D Line that matters (it's an arbitrary number), but the change in the A/D line. An upward sloping A/D line coupled with an upward sloping market means that the market's increases are due to an abundance of advancing stocks in the market.
When the A/D Line's trend becomes out of synch with the broad market, it suggests that the market is losing breadth and may be due for a reversal.
Scores of popular market breadth indicators are available in most charting software packages. Select one that makes sense to you, and you can start applying breadth measures to the broad market to spot signs of weakness. Remember that indicators like market breadth are confirmatory -- wait for a technical signal based on price action before trading them.
In the mean time, do you have a burning technical analysis question? Get it answered by heading to Stockpickr Answers.
-- Written by Jonas Elmerraji in Baltimore.
Jonas Elmerraji, based out of Baltimore, is the editor and portfolio manager of the Rhino Stock Report, a free investment advisory that returned 15% in 2008. He is a contributor to numerous financial outlets, including Forbes and Investopedia, and has been featured in Investor's Business Daily, in Consumer's Digest and on MSNBC.com.